Wednesday, November 20, 2013

Jeremy Grantham is the co-founder and chief investment strategist of GMO. His letters are widely followed due to his decades of experience and ability to take a rational look at what is taking place in the financial markets.

I have provided his most recent letter below, but for those looking for the brief summary on where he feels the market is headed; he believes that the fair value of the S&P 500 is currently around 1100 based on the economic fundamentals that surround it. With the S&P 500 touching 1800 earlier this week that may create some concern for long term "value" investors (currently 75% overpriced).

However, due to the irrational exuberance surrounding the market today, he feels that stocks could melt up higher over the next year before they once again find gravity and we enter the third major crash of the last 15 years. His conclusion sums it up best:

“One of the more painful lessons in investing is that the prudent investor (or “value investor” if you prefer) almost invariably must forego plenty of fun at the top end of markets. This market is already no exception, but speculation can hurt prudence much more and probably will. Ah, that’s life. And with a Fed like ours it’s probably what we deserve.”

“Be prudent and you’ll probably forego gains. Be risky and you’ll probably make some more money, but you may be bushwhacked and, if you are, your excuses will look thin. Your call. We of course are making our call.”

The following video provides an animated review of what took place during the Mississippi bubble in the early 1700's. As human psychology has changed little over the centuries, meaning that speculative bubbles will always exist, it is important to review the past to understand the why around the irrationality of the future.

Monday, November 18, 2013

When I discussed bitcoin over the weekend in Bitcoins Go Parabolic: Time To Buy Or Sell? the price was at $450. Just a few hours later it has crossed $775. The following ticker will provide a real time bitcoin bubble update. Get your popcorn ready and place your bets on how far this ridiculous number will rise.

The following is a brief walk through of how the QE process works in the United States. The Federal Reserve buys treasuries and mortgage bonds from primary dealers (the largest banks) and give them cash. These purchases with printed money are shown in the growth of the monetary base:

The banks then take that cash and re-deposit the money back with the Federal Reserve earning interest on these deposits. The deposits also allow them to have a capital base to speculate in the stock market and other risk assets with leverage. The following chart shows the re-depositing of the fresh cash with the Fed known as excess reserves:

During this process you will notice that Main Street has been cut out of the loop. They do not receive loans from the banks as they once did in the past. Instead, this cartoon sums up what is left for "the rest."

Sunday, November 17, 2013

It's hard to believe, but this is my first time discussing bitcoin on this site. Before reviewing what bitcoin is, I will tell you a very sad story, which will simultaneously provide context to this discussion.

I was introduced to bitcoin years ago when it was trading at 6 cents. A paid publication that I read discussed the new product in detail. I chose not to purchase any bitcoins at the time.

Fast forward to today and bitcoin is now crossing 450 dollars. Very simple math shows you how little money I would have needed to invest at 6 cents to make a fortune on the speculation. That is the sad part of the story, and it is very sad.

The context is the why? Why did I choose not to buy?

Bitcoin was designed as an electronic currency to compete with other available currencies, or stores of wealth. Its main draw is scarcity. There is a limited number of electronic bitcoins that were created and available to purchase around the world. New bitcoins can be created, but they must be "mined" electronically, a process that takes the top miners a good amount of time. Therefore, the new supply enters the market at a slow pace and ensures the scarcity factor is always there.

Compare this with the other major competing currencies around the world that are flooding the market with new supply through QE programs and devaluing the currency that already exists. The first group of bitcoin buyers were most likely people that were looking for another safe harbor against that devaluation.

The current buyers, I suspect, are something different altogether. The chart below provides the price movement for the electronic currency. You can see the initial thrust up to almost $250 as the product first gained mainstream awareness and the collapse in price that brought it quickly down to almost $50. It has since regained its footing and is now on a truly spectacular trajectory.

I believe the bitcoin chart above will eventually be used in discussion boards to define what a speculative bubble looks like. It will be put up alongside the tulip bulb mania of 1634 (below).

Part of the discussion in the future will center around the fact that bitcoins have less real world value than a tulip bulb. It is an electronic currency backed by nothing. It was just something thought up and sold to the world. Tulips had value in that at least you could plant them in front of your home. While the rise in bitcoins could end up even more spectacular than what was seen hundreds of years ago in tulips, the collapse will most likely also be greater. Reports are out now that the Chinese (known for their love of gambling and speculation) are entering the bitcoin market with force to ride the speculative wave higher.

The story itself has flair in that the Winklevoss twins (from Facebook) have become large investors, even promoting the currency on television as "extremely undervalued."

So back to my personal sad story. Why did I choose not to invest at 6 cents?

There is another option for investors who are looking to put their money into a form of currency that cannot be devalued: precious metals. Just as with bitcoins, there is a limited supply available on the planet and it takes years to set up a mine to bring new supply online. Precious metals have the same exact scarcity feature with one important difference; they have real tangible physical form. They exist.

I believe that before this decade is over the silver chart is going to take the form of the bitcoin chart above. The first silver blast off to $50 was the opening act (just as with bitcoin) and the main event is still coming. The fact that everyone around the world would line up to buy an artificial currency at $450 only strengthens my belief that someone out there would want to purchase a physical silver coin (which has represented real money for thousands of years) for $20.

Will I buy some bitcoins if they cross $1,000? Unfortunately, no. I will continue to buy boring physical silver coins at $20 (and hopefully much lower if prices fall) that everyone hates. I enjoy watching the bitcoin story, because as I mentioned before, it could end up being the greatest speculative bubble in world history before it completely collapses.

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.